As The S&P 500 Reaches New Highs, Asset Inflation Continues

Earnings are expected to decline with economic outlook being constantly revised downwards.

Gold is gaining alongside stocks which confirms that all assets are inflated.

Introduction

Amidst all the turmoil from BREXIT, negative interest rates and global downward economic growth forecasts, the S&P 500 has reached a new high. On Monday it closed at 2,137.16 points, overtaking the previous high of 2,130.82 from May 21, 2015. The Monday record was surpassed again on Tuesday and Wednesday, with Wednesday closing at 2,152.43.

This new high isn’t significant in terms of real returns as the market hasn’t really gone anywhere in the last 14 months, but it is significant from a psychological and confidence perspective. In this article we are going to look for the breakout reasons and fundamentals, and analyze potential risks.

Fundamentals

It’s pretty straightforward: if earnings grow then the S&P 500 is also supposed to grow, if earnings decline and the S&P 500 grows we can assume we are in a bubble. At the moment, earnings are not growing and this earnings season will probably be the fifth consecutive quarterly earnings decline. In total, net income is down 18% since its 2014 high.

The 18% decline isn’t that bad when compared to the average 36% earnings decline in recessions since 1936, but currently we are not even close to being in a recession.

Investors seem optimistic and willing to pay a hefty premium for stocks. The current S&P 500 PE ratio is approaching 25 and it has been higher than 25 on only two occasions in the last 100 years, in the dotcom bubble and in the midst of the Great Recession when earnings plunged.

As earnings are not growing and fundamentals are deteriorating, there must be something else that creates investor optimism.

Economic Data

As stock prices reflect future expectations, a look at GDP forecasts will give a good perspective on the rationality of the above valuations. In June, well before the BREXIT vote, the World Bank lowered its global growth forecast from 2.9% to 2.4% indicating more trouble for corporations. The International Monetary Fund has cut its forecast for the U.S. from 2.4% to 2.2% for 2016 but expects a pickup to 2.5% in 2017, while the FED expects moderate and stable economic growth at 2% for the next few years. In greater detail, the media highly promoted the 287,000 new jobs added recently but failed to focus on the increased unemployment rate from 4.7% to 4.9%.

One might wonder if the above mentioned data is enough to sustain a PE ratio of 25 as historically the economy has grown faster than 2% and the S&P 500 has had lower PE ratios, again an indication that asset prices are inflated.

Low Bond Yields

The inflation in asset prices is especially visible in fixed income investments. With 30% of global sovereign debt charging a negative yield, investors push bond prices higher and higher in a desperate search for positive yields. This is further enhanced by the central banks of Europe and Japan actively buying corporate bonds on the market, and even stocks for the latter. As long as central banks relentlessly continue buying securities, it is very difficult for stock markets to experience substantial declines which means that small risks are being smoothed out by monetary policies while the big black looming risk grows bigger and bigger.

Not only that, but capital flows toward fixed income funds are reaching record highs.

One could argue that the above mentioned corporate earnings decline is mostly the result of lower commodity prices and declining earnings in the energy sector, but only 4 of 10 sectors will see earnings growth in the coming earnings season.

Despite that the energy sector is expecting the worst decline in earnings, its performance in the last 6 months has been the best as things have stabilized a bit. On the other hand, the fact that utilities, energy and materials were the best performing sectors in the last 3 months shows that investors are looking for investments that protect against inflation and have constant, recession-proof yields.

Gold is usually not correlated with stocks, but from the chart above we can see that both gold and stocks are increasing which again leads toward the conclusion that all asset prices are inflated.

What To Do

It is difficult to be smart in such an artificially created situation, but stock picking and “stick to what you know” might be the best option. You must evaluate the companies in your portfolio and identify how they will perform in the uncertain times that are ahead as asset inflation, possible real inflation in the future, and higher rates will wreak havoc among securities.

Now is the time to be smart. Investors should grasp the opportunities given by the high liquidity but at the same time think of the potential risks if anything changes in the current financial monetary easing system.